2014 Series • No. 14–12
Research Department Working Papers
Saving for a Rainy Day: Estimating the Appropriate Size of U.S. State Budget Stabilization Funds
Rainy day funds (RDFs) are potentially an important countercyclical tool for states to stabilize their budgets and the overall economy during economic downturns. However, U.S. states have often found themselves exhausting their RDFs and having to raise tax rates or reduce expenditures while still experiencing a downturn. Therefore, how much each state should save in its RDF has become an increasingly important policy question. To address this issue, this paper applies several new methodologies to develop target RDF levels for each U.S. state, based on the estimated short-term revenue component associated with business cycles and also on policymakers' preferences for stable tax rates and expenditures.
Key Findings
- RDFs are an increasingly important and necessary countercyclical tool for states, as states have experienced significant negative revenue fluctuations in economic downturns in the last 25 years, especially during the recessions of the 2000s.
- There is no "one-size-fits-all" optimal size RDF; the size of the needed RDF varies across states.
- Many states have imposed caps on their RDFs that are lower than the size of the needed RDF.
- In the last 25 years at least 21 states have never saved enough in their RDF relative to their needed RDF.
Implications
These results have important implications for reforming state RDFs across the country. This paper suggests that many states may consider raising or removing their RDF cap to improve the RDF effectiveness. States should consider saving more than they historically did in order to be better prepared when future economic downturns occur.
Regarding methodology, the paper shows that the linear time model, which is the standard approach in the literature, has serious flaws and should not be used to estimate the short-term revenue component associated with business cycles; the author provides evidence that the HP filter produces a more plausible estimate of the short-term revenue component and the needed RDFs than any of the other methods considered.
Abstract
Rainy day funds (RDFs) are potentially an important countercyclical tool for states to stabilize their budgets and the overall economy during economic downturns. However, U.S. states have often found themselves exhausting their RDFs and having to raise tax rates or reduce expenditure while still experiencing a downturn. Therefore, how much each state should save in its RDF has become an increasingly important policy question. To address this issue, this paper develops target RDF levels for each U.S. state, based on the estimated short-term revenue component associated with business cycles and also on states' preferences for stable tax rates and expenditure. The analysis shows that in the last 25 years at least 21 states have never saved enough in their RDFs relative to their needed RDFs. The paper provides policy recommendations on reforming the RDF caps.